Owning a home is a dream for every family, but owning it often involves taking out a loan. A loan is a long-term financial commitment, and finding ways to optimize it can lead to substantial savings and financial security. One practical and effective strategy homeowner can employ is regularly pre-paying a portion of their home loan. In this article, I will explain why it is better to pre-pay part of your home loan regularly and ways to do it.
Understanding Home Loans and Prepayment
Before we get into the benefits of pre-paying a home loan, it’s essential to understand what home loans and prepayments are;
What is a Home Loan?
A home loan is a financial product that allows individuals to purchase a home by borrowing money from a lender (bank). The borrower (you) agrees to repay the loan amount over a specified period, usually 15, 20, or 30 years, along with interest.
What is Prepayment?
Home loan prepayment refers to making additional payments toward the principal loan amount in addition to the regular EMI (Equated Monthly Instalment). These extra payments can be made anytime, reducing the loan’s outstanding balance. However, rules differ from bank to bank. Many banks do not allow the borrower to make early prepayments as the bank knows the maximum interest they can earn as a lender is at the beginning of the loan tenure. Hence, checking prepayment conditions while you opt for the loan is essential.
Related Article : Latest Floating Rate Reset Rules on Loans | RBI’s (2023) Guidelines
The Benefits of Regular Home Loan Pre-payments
Now that we have a basic understanding of home loans and prepayment let’s explore the numerous advantages of regularly pre-paying your home loan.
(1) Interest Savings
One of the most compelling reasons to make regular prepayments is the significant interest savings over the life of the loan. When you make additional payments towards the principal, you reduce the outstanding balance on which interest is calculated. As a result, you’ll pay less interest over the long term, potentially saving lakhs.
(2) Faster Loan Closure
Regular prepayments accelerate the process of paying off your home loan. Reducing the principal balance can shorten the loan term, allowing you to become debt-free sooner than planned. This can free up your cash flow for other goal investments such as retirement planning or your children’s education.
(3) Improve Financial Security
Paying off your home loan faster reduces your debt and enhances your financial security. Owning your home outright means you won’t have to worry about loan payments, providing peace of mind and financial stability during your lifespan.
Strategies for Regular Prepayments of Home Loan
Now that we’ve understood the benefits of regular loan prepayments, let’s explore some practical and effective strategies to incorporate this practice into your financial plan.
(A) Lump Sum Payments
Consider lump sum payment towards your home loan principal whenever you have extra funds, such as a bonus tax refund; this can immediately impact your loan balance.
Let’s compare the scenarios.
|Scenario-1 (Continue Loan As Scheduled)|
|Annual Interest Rate||8%|
|Loan Period in Year||20|
|Scenario-2 (Extra Payment Made Annually- Rs. 5 lakhs)|
|Annual Interest Rate||8%|
|Loan Period in Year||20|
|Extra Payment Made Annually||5,00,000|
|Loan Period in Year Reduced To||9.6|
|Total Early Payment||47,50,000|
|Interest saved with Prepayment||57,54,497|
The benefits of regularly pre-paying your home loan can clearly be seen in the above example. It doesn’t matter if it is a small or more significant amount. Prepayment is going to be helpful.
(B) Opt for a Higher EMI
An alternative, highly effective approach to speed the closure of your home loan involves selecting a higher Equated Monthly Instalment (EMI). By doing this, you can reduce the overall interest cost and the loan tenure. However, you must work on your budget before opting for a higher EMI. The best time to do this exercise is when your salary increments either in the same organization or by the change in job.
Let’s understand with an example. In that case, if opting for a higher EMI is better or saving separately for early loan closure is better:
Sunil has a 20-year home loan of Rs. 42 lakhs at 9.1% (base rate, so it didn’t change much) from XYZ Bank with a monthly EMI of Rs. 38,000, and he can spare Rs. 12,000 more per month for investment (or) pre-paying home loan.
Case 1: If Sunil invests Rs. 12,000 per month in mutual fund SIP
|Interest Assumption in Mutual Fund SIP in 12 Years||10%|
|Principal (12,000 X 12 X12)||₹ 17,28,000|
|Investment Value||₹ 33,17,000|
|Funds Available for loan closure (post-tax)||₹ 31,68,000|
|Outstanding home loan principal||₹ 31,67,000|
|Loan outstanding amt. after 12 years||₹ 26,07,000|
|Excess Amt. available after loan payment||₹ 5,61,329|
|Tax Benefit in Home Loan in 12 years||₹ 7,20,493|
|Total Loan Interest Payable in 12 years||₹38,69,174|
|Post Tax Benefit- Loan Interest Payable in 12 years||₹ 31,48,681|
Continuing the loan with an EMI of Rs. 38,000 and investing Rs. 12,000 in SIP with the expected return of 10%. The loan can be closed in 12 years with excess funds available in the hands – Rs. 5.61 lakhs or in 11.1 years with no cash available in hand.
Case 2 : If Sunil pre-pays a home loan by paying Rs. 50,000 instead of Rs. 38,000 per month
In this case, the loan can be closed in 12 years. Here, you will think case-1 is better as it will leave excess cash of Rs. 5.61 lakhs in hand.
However, do not decide without understanding how much interest you will pay the bank in both cases.
|Total Loan Interest Payable in 12 years||₹ 24,61,725|
|Tax Benefit in Home Loan in 12 years||₹ 5,39,484|
|Post Tax Benefit- Loan Interest Payable in 12 years||₹ 19,22,241|
Difference in interest (Case 2 – Case 1): 12.26 lakhs
Looking at the above calculation, it can be said opting for a higher EMI is financially better as we can save significant interest. Ultimately, it matters what’s going out of your pocket. However, such analysis is more situational-based. One must do the calculations and decide whether to invest the monthly surplus or opt for a higher EMI.
The outcome can differ based on:
- The outstanding number of years of the loan
- The additional amount. available for an increase in EMI / investment
- Home loan interest
- Expected return on investment
- Home loan holding pattern (self or self & spouse).
Factors to Consider while pre-paying your Home loan
While pre-paying your home loan offers numerous benefits, here are some factors you must consider before implementing this strategy.
- Prepayment Penalties : Some banks/ lenders penalize borrowers for pre-paying the loan early in the loan tenure. Understanding these terms and factoring them into your prepayment strategy is essential. Review your loan contract to identify any terms or conditions regarding penalties for making prepayments.
- Emergency Fund : Before committing to regular prepayments, ensure you have an adequate emergency fund. It’s crucial to have savings set aside for unexpected expenses or emergencies to avoid financial strain.
- Review short-term goal : Review if you lack funds for any short-term goals. If any, consider saving for short-term goals first to avoid immediate financial stress.
- Investment Opportunity Cost : Consider the opportunity cost of using extra funds to pre-pay your mortgage versus investing them elsewhere. Depending on the interest rate on your loan and potential investment returns, investing the money elsewhere for long-term goals may be more advantageous.
Regularly pre-paying your home loan can benefit you in many ways, including interest savings, faster debt reduction, improved financial security, etc. By implementing the shared prepayment strategies, you can become debt-free quickly and take control of your financial future. These strategies can also be applied to other types of debt, like car loans, education loans, etc. Lastly, pre-paying your loan is a powerful strategy for securing your financial future.
Salm Sony is the author of this article. She is the founder of salmasony.com
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(Post first published on : 04-Sep-2023)